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Part 2International

Corporate Finance -

Lecture n° 10Repositioning funds and working

capital management

International Finance

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Repositioning Funds

As an MNE aims at maximizing the shareholder value, one of its tasks is to reposition the profits as legally and as practically as possible, in low tax environments.

Repositioning profits is also useful to redeploy cash-flows or fund in more value-creating activities, or to minimize exposure to a currency collapse, or political crisis.

To this end, it can use a variety of techniques : Unbundling fund transfers Dividend remittances Payment of fees Home overhead charges

Example : Trident has operations in Brazil, China and Europe, each with their own constraints and opportunities for Trident to reposition funds

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Repositioning Funds

Trident CorporationTrident Corporation(Los Angeles, USA)

Trident China(Shanghai, China)

Trident Brazil(Sáo Paulo, Brazil)

Trident Europe(Hamburg, Germany)

Currency: the dollar (US$)Tax rate: 35%Capital restrictions: None

Country:

GreenfieldInvestment

AcquisitionInvestment

Joint VentureInvestment

Currency: the euro (€)Tax rate: 45%Capital restrictions: None

Country:

Subsidiary status:

Business: mature

Currency: the real (R$)Tax rate: 25%Capital restrictions: Some

Country:

Subsidiary status:

Business: immediate growth potential

Currency: the renminbi (Rmb)Tax rate: 30%Capital restrictions: Many

Country:

Subsidiary status:

Business: long-term growth potential

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Repositioning Funds

The strategy for each subsidiary will be Trident Europe – reposition profits from Germany

to the US while maintaining the value of the European market’s maturity

Trident Brazil – reposition or in some way manage the capital at risk subject to foreign exchange risk while still providing adequate capital for growth

Trident China – reposition the quantity of funds in and out of China to protect against transfer risk while balancing the needs of the joint venture partner

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Repositioning Funds

Constraints on Positioning funds: Political constraints : governments can block the

movement of funds (transfer risk). Tax constraints : tax liabilities may prohibit fund

transfer; tax structures may be complex and possibly contradictory.

Transaction costs : foreign exchange conversion and fees for money transfers. Become significant for large or frequent transfers. MNE avoid then unnecessary back-and-forth transfers.

Liquidity needs : each subsidiary needs to maintain adequate working capital.

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Conduits for Moving FundsForeign Subsidiary’s Income Statement

SalesCost of goods soldGross profit

General & administrative expensesLicense feesRoyaltiesManagement feesOperating profit (EBITDA)

Depreciation & amortizationEarnings before interest & taxes (EBIT)

Foreign exchange gains (losses)Interest expensesEarnings before tax (EBT)

Corporate income taxNet income (NI) Dividends Retained earnings

Payments to parentfor goods or services

Payments for technology,trademarks, copyrights, management or othershared services

Payments of interestto parent for intra-firm debt

Distribution ofdividends to parent

Before-Taxin the

Host Country

After-Taxin the

Host Country

Payment to Parent Company

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Transfer Pricing

Transfer pricing : pricing of goods and services transferred to a foreign subsidiary from an affiliated company.

A parent wishing to reposition funds out of or into a particular country can charge higher or lower prices on goods sold among subsidiaries This will affect the income statement of the

subsidiary and effectively raise or lower taxes, with an opposite effect on the selling subsidiary.

Efficient conduit to avoid high taxation environments, but subject to abuses and, therefore, controls by the fiscal authorities. (see examples)

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Transfer Pricing

Methods of determining transfer prices Comparable Uncontrolled Price Method

Regarded as the best evidence of arm’s length pricingA market determined price

Resale Price MethodSubtracts appropriate markup for the distribution subsidiary

from the final selling price to an independent purchaser Cost-Plus Method

Sets price by adding a appropriate profit markup to the seller’s full cost

Often used where semi-finished products are sold between subsidiaries

Other Pricing MethodsSome tax authorities allow low pricing for establishment of

new market so long as the cut price is passed on to final customer

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License, Royalty Fees & Shared Services

License fees : remuneration paid to the owners of the patents, technologies, trade names, etc. Usually based on a percentage of the value of the product or

the volume of production

Royalty fees : similar compensation paid for the use of intellectual property

Such fees are typically paid for identifiable services received by the subsidiary

Shared services : also referred to as distributed charges or overhead, are charges to compensate the parent for costs incurred in the general management of international operations and other corporate services provided to the subsidiary.

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Dividend Remittances

The classic way in which funds are transferred from subsidiary to parent

Dividend payout policies have change over the years and now incorporate several variables in determining the payout strategy. These are : Tax implications : dividends are very tax-inefficient Political risk : incite firms to remit all funds locally generated

that are not necessary to locally. Foreign exchange risk : if an FX loss is anticipated, the MNE

will speed the transfer of funds. Distributions and cash flows : growth is not always

accompanied with liquidity, especially is working capital funding are high.

Joint venture factors : firms may be reluctant to vary the level of dividends paid, and tying its obligations toward the partner.

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Leads and Lags

Firms can reduce both operating and transaction exposure by accelerating or decelerating the timing of payments that must be made or received in foreign currencies

To lead is to pay early A firm holding a “soft currency” or debts denominated in

“hard currency” will lead by using the soft currency to pay off the debts before the soft currency loses value.

To lag is to pay late A firm holding a hard currency and debts denominated in

soft currency will lag by using the hard currency to pay off the debts in hopes of having to use less of the hard currency

Leading and lagging is more feasible within a related firm

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Reinvoicing Centers

A reinvoicing center is a separate corporate subsidiary that serves as an intermediary between the parent and all foreign subsidiaries. Title of ownership and invoices pass through the center but the physical movement of goods is direct.

Advantages Managing foreign exchange exposure is centrally located for

all subsidiaries allowing center to attain specialized expertise Guaranteeing the exchange rate for future orders can be

done through the center by setting firm local currency costs in advance

Managing intra-subsidiary cash flows, including leads and lags of payments is better managed and allows center to hedge only the net exposure of cash flows

Disadvantage : that the cost of center may be greater than the benefits attained.

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Working Capital Management

The operating cycle of a business generates funding needs, cash inflows and outflows – the cash conversion cycle – and foreign exchange rate and credit risks.

The funding needs generated by operations of the firm constitute working capital.

The cash conversion cycle is the period of time extending between cash outflows for purchased inputs and cash inflow from cash settlement.

The entire process from stage t0 to t5 is the company’s operating cycle.

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The Operating Cycle

Cash Conversion Cycle

CashPayment

for Inputs

CashSettlementReceived

Operating Cycle

PriceQuote

OrderPlaced

QuotationPeriod

t1

InputsReceived

InputSourcing

Period

t2

OrderShipped

InventoryPeriod

t3

AccountsPayablePeriod

t4

PaymentReceived

AccountsReceivable

Period

t5

timet0

TheFirm

CashOutflow

CashIntflow

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Net Working Capital (NWC) is the net investment required of the firm to support on-going sales. NWC components typically grow as the firm buys inputs, produces product, and sells finished goods.

Days working capital is a common method used to calculate the NWC of a firm : This method is based on using a “days sales” basis : if the value of A/R, inventories and A/P are divided

by the annual daily sales The firm’s NWC can be summarized in the number of days sales of NWC. These results vary among

industries and countries.

Working Capital Funding

(A/P) - Inventory) (A/R C)capital(NW gNet workin

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Working Capital Financing

Managing Receivables A firm’s operating cash inflow is derived primarily from the

collection of receivables There are several factors that go into the management of

receivablesIndependent customers – requires decisions about currency

of denomination and payments termsPayment termsSelf-liquidating bills – secured by physical inventory that

has been sold and the funds are lent based on the securitization

Other terms Inventory Management

Anticipating devaluation – management must decide whether to build inventory of items that carry foreign exchange exposure

Anticipating price freezes

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International Cash Management

International cash management is the set of activities determining the levels of cash balances held throughout the MNE, cash management, and the facilitation of its movement cross border, settlements and processing

Cash levels are determined independently of working capital management decisions Cash balances, including marketable securities, are held partly for

day-to-day transactions (transaction motive) and to protect against unanticipated variations from budgeted cash flows (precautionary motive)

Cash disbursed for operations is replenished from two sources Internal working capital turnover External sourcing, traditionally short-term borrowing

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International Cash Management

All firms engage in some sort form of the following steps: Planning – a financial manager anticipates cash flows over

future days, weeks, or months. Collection – controlled through time lags between the

shipment date and the payment date. Disbursement – steps included are avoiding unnecessary

early payment, maximizing float and selecting a disbursement bank.

Covering cash shortages – anticipated cash shortages can be managed by borrowing locally.

Investing surplus cash – if a subsidiary of an MNE generates surplus cash, the MNE must decide whether to handle its own short-term liquidity or whether surplus funds should be controlled centrally.

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International Cash Settlements

Four techniques for simplifying and lowering the cost of settling cash flows between related and unrelated firms Wire transfers : Variety of methods but two

most popular for cash settlements are CHIPS and SWIFT

Cash pooling Payment netting Electronic fund transfers

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International Cash Settlements

Cash Pooling and Centralized Depositories Businesses with widely dispersed operating

subsidiaries can gain operational benefits by centralizing cash management.

Subsidiaries hold minimum cash for their own transactions and no cash for precautionary purposes.

All excess funds are remitted to a central cash depository.

Information advantage is attained by central depository on currency movements and interest rate risk.

Precautionary balance advantages as MNE can reduce pool without any loss in level of protection.

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International Cash Settlements

Multilateral Netting Defined as the process that cancels via offset

all, or part, of the debt owed by one entity to another related entity.

Netting of payments is useful primarily when a large number of separate foreign exchange transactions occur between subsidiaries.

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Financing Working Capital

All firms need to finance working capital and most of the short-term financing needs is done through the use of bank credit lines.

Banking sources available to MNEs are : In-house Banks : set of functions performed by the

existing treasury department, providing banking services to the various units of the firm.

Commercial Banking Offices :Correspondent Banks with local banks across the worldRepresentative Offices established in a foreign country Branch Banks and Affiliates